Who's Going To Pay The 3.8% Medicare Surtax?

Unless you’ve been stranded on a desert island, you’ve probably heard about the 3.8% Medicare surtax scheduled to take effect in 2013. This provision was included in the controversial health-care law—the Patient Protection and Affordable Care Act of 2010—upheld recently by the U.S. Supreme Court. Barring any late reprieve from Congress, investors will have to cope with this add-on tax for the foreseeable future.

How does it work? You must use a two-part test when you complete your tax return. The 3.8% Medicare surtax applies to thelesser of (1) “net investment income” or (2) the amount by which your modified adjusted gross income (MAGI) exceeds a threshold amount. Net investment income includes interest, dividends, royalties, rents, gains from selling property (other than property held in an active trade or business), and income from passive activities, but not tax-exempt interest or distributions from IRAs and qualified retirement plans.

For single tax filers, the threshold is $200,000; for joint filers, it’s $250,000. The way the law is applied might result in an unexpected tax for some individuals, while others could escape unscathed. Here are six simplified examples:

Example 1. Alan is a single filer who each year earns $100,000 in wages and $50,000 of net investment income. Because his MAGI doesn’t exceed the $200,000 level, Alan doesn’t have to worry about the 3.8% Medicare surtax. It applies to investment income only if MAGI goes beyond the threshold.

Example 2. Barbara is a single filer who is retired. She has no wages and her entire MAGI comes from $225,000 of net investment income. Barbara does have to pay the 3.8% surtax on the MAGI part, even though she has no wages, because her $25,000 that exceeds the threshold is less than her investment income of $225,000. Her bill for the Medicare surtax is $950 (3.8% of $25,000).

Example 3. Charles and Donna, a married couple, are joint filers. They earn a total of $300,000 in wages, but have no net investment income. As a result, the couple doesn’t have to pay the 3.8% Medicare tax, even though their MAGI exceeds the threshold for joint filers by $50,000. Their net investment income, which is the lesser of the two applicable amounts, is zero.

Example 4. Edward and Florence, a married couple, are joint filers. They earn a total of $200,000 in wages and have $150,000 of net investment income. Their $350,000 MAGI exceeds the threshold of $250,000 by $100,000. Because that’s less than their investment income, it’s their excess MAGI that is subject to the Medicare surtax. The couple must pay $3,800 (3.8% of $100,000).

Example 5. Gerard is a single filer who is retired. He has no wages and $200,000 of net investment income in 2013, but he also will receive a “required minimum distribution” (RMD) from his IRA of $125,000. The RMD doesn’t add to his investment income, because IRA distributions don’t count as investment income for the purposes of computing the Medicare surtax. But the money from his retirement plan does increase Gerard’s MAGI to $325,000. The $125,000 by which that amount exceeds the $200,000 threshold is less than his $200,000 of investment income, so his surtax is calculated on the $125,000—leaving Gerard with a Medicare surtax of $4,750 (3.8% of $125,000).

Example 6. Hillary is a single filer who is retired. She has no wages and each year receives $100,000 in tax-exempt interest from municipal bonds, a $200,000 RMD from her IRA, and a $300,000 RMD from her 401(k) plan. As a result, none of the annual income that Hillary receives is treated as net investment income. She doesn’t have to pay the 3.8% Medicare because her net investment income is zero, which is lower than the $300,000 by which her MAGI exceeds the $200,000 threshold. (Tax-free interest also doesn’t count toward MAGI.)

Note that the 3.8% Medicare surtax also applies to trusts and estates. In those cases, the threshold for single or joint filers is replaced by the dollar figure at which the top tax rate for trusts and estates begins ($11,650 in 2012). That means that if all of the trust income is net investment income and the undistributed net investment income exceeds the dollar threshold by, say, $100,000, the trust must pay a Medicare surtax of $3,800 (3.8% of $100,000).

Are you among the unfortunate ones who will have to pay the 3.8% Medicare surtax? Don’t just sit back and wait for it to happen. With advance planning, you may be able to reduce your MAGI or your net investment income—or both—to help offset the impact of the surtax.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.